It is hard to find fiscal situations that are worse than Japan's. The gross government debt/GDP ratio, at more than 200%, is the worst among the major developed economies. Yet yields on Japanese government bonds (JGBs) have not only been among the lowest, they have also been stable, even during the recent deterioration during the European debt crisis. This apparent contravention of the laws of economics is both an enigma for foreign investors and the reason for them to expect fiscal collapse as a result of a sharp rise in selling pressure in the JGB market. As Goldman notes, the European debt crisis has led to an increase in market sensitivity to sovereign risk in general and questions remain on when to expect the tensions in the JGB market and the fiscal deficit to reach a breaking point in Japan. In the following 14 charts, we explore the sustainability of fiscal deficit financing in Japan and Goldman addresses the JGB puzzles.

Goldman Sachs: Japan’s fiscal/JGB enigma and conceptual framework

A financial crisis can come about as a result of a lack of solvency or liquidity. Solvency is a government’s ultimate ability to pay its debts. Liquidity is concerned with the “here and now”: can a government fund its ”current” fiscal deficit in a particular fiscal year? In terms of solvency, there are massive concerns about Japan. Despite these concerns, domestic investors have poured funds into the JGB market. As a result, Japan currently has no liquidity problem at all, which may seem strange at first glance.

Even the government’s primary balance forecast, based on a growth-strategy scenario that is far more optimistic than private-sector forecasts, does not predict primary surpluses in the next ten years (it assumes a total of 5 percentage point increase in the consumption tax rate until October 2015). We conclude from this that Japan’s debt/GDP ratio can only be stabilized through deep spending cuts that will necessarily include cuts in areas such as social security, and believe this will be extremely difficult to achieve politically.

One reason why Japanese investors continue to invest in JGBs despite solvency concerns is that firms are saving sufficiently.

Falling growth expectations as a result of Japan’s ageing demographics have eroded the incentive to invest and borrow. Money with nowhere to go is therefore being channeled into the JGB market via banks and other domestic financial institutions. Even if investors want to move out of JGBs, the funds are so large that there is no yen financial market of an equivalent size and liquidity. There have been some moves into US Treasuries and Bunds but Japanese investors have a strong ”home bias” and such fund transfers have been limited, at least thus far. Money has therefore stayed in the domestic market, funding the fiscal deficit even when negative factors have arisen. Hence, liquidity has so far not been a problem.

Why are JGB yields so low and stable in the face of major solvency concerns? This has been an enigma for foreign investors. We address this question by breaking down the nominal yield into (1) real interest rates, (2) inflation expectations, and (3) a fiscal premium.

(1) The real interest rate is generally approximated by the real potential growth rate over the long term. It has fallen sharply in the past two decades due to rapid ageing of the population. In turn, firms have lost some of their capex incentive and thus shifted from cash shortfalls to cash surpluses.

(2) Inflation expectations have fallen in Japan because nominal wage cuts in the late 1990s have led to widespread deflation expectations.

(3) So far the JGB market has not factored in a fiscal premium to a significant extent. This is very different from the sovereign Credit Default Swap (CDS) market, where pricing is largely determined by foreign investors. Japan’s sovereign CDS spread, which can be seen as an objective assessment of the government’s solvency, has been rising since the late 2000s. We believe the JGB market’s lack of a fiscal premium is due to the stable domestic uptake of JGBs.

Japan’s fiscal sustainability

To assess Japan’s fiscal sustainability, it is therefore more important to look at it in terms of liquidity rather than solvency. Specifically, we need to assess how long the surplus funds of domestic private agents can absorb fiscal deficits. We project this situation out to FY2020 using a two-pronged approach based on an investment/savings identity. Our first, direct approach is to model the savings behaviour of firms and households. Our second approach is to start from the current account balance, which is equivalent to the overseas sector’s savings that appear as the result of our first approach. This is an indirect method for exploring the domestic potential for fiscal deficit funding. The two approaches complement each other, with reality likely to be somewhere between the two simulations.

The most important underlying factor in our first approach is population ageing.

This is a negative for household savings but positive for corporate savings. To gauge the outlook for domestic uptake of fiscal deficits, we combine our estimates for the cash surpluses of domestic private agents with the government’s forecast for the fiscal deficit.

In a scenario where the deficit is not reduced by more than what the current government plans and the fund outflow of overseas M&A by Japanese firms is taken into account, we find that it would become difficult to fully finance the deficit domestically by FY2018. However, the Japanese government is considering another consumption tax hike beyond the currently-planned 5% increase by FY2015. Thus, for example, if we apply a hypothetical (but realistic, in our view) scenario of a further three percentage point increase in consumption tax rate or an equivalent cut (at least ¥6tn) in permanent fiscal expenditure, we find that the deficit can comfortably be funded domestically through FY2020, the end of our analysis period.

However, we note that measures such as the currently-planned five percentage point increase in consumption tax rate are far from sufficient to solve the solvency problem as they do not address the issue of stabilizing the debt/GDP ratio. We believe they are just stopgap measures to keep the wheels turning even as domestic savings dry up.

Current account outlook

Our second approach is to look at the current account outlook in that it will move into deficit if domestic cash surpluses are unable to finance the fiscal deficit. We simulated the current account up to FY2020 using conservative assumptions: further yen appreciation, offshore production shifts by manufacturers and continued imports of energy alternatives to nuclear power. Our conclusions are as follows:

If overseas production shifts continue at their historical pace (taking the overseas production ratio to 24% in FY2020, from about 18% in FY2010), we would not expect the current account to move into deficit by FY2020.

We would likely see widening trade deficits as (1) offshore production reduces exports and increases imports, and (2) imports are boosted by alternative energy sources. However, large trade deficits are not expected to occur quickly because a fall in exports acts as a curb on imports.

The income account, which has been at the heart of current account surpluses since the mid-2000s, features an increase in earnings from direct investment as a result of offshore production shifts. This mitigates the effect from the widening trade deficits and results in a very gradual deterioration of the current account.

However, in an extreme case where the shifts far exceed their historical pace, taking the overseas production ratio to 33% in FY2020 from around 18% in FY2010, trade deficits would widen much more quickly and the current account would likely move into deficit in FY2019.

The foreign incentive to invest in JGBs

The foreign ownership ratio for JGBs has risen to 8.3% (as of end-March 2012) from its most recent low of 5.7% (end-March 2010), prompting two questions among foreign investors in particular: (1) Why has the JGB yield not risen along with foreign ownership ratio (why are foreign investors not demanding a fiscal premium)? and (2) Will the foreign presence escalate to, say, well above 10% in the near future?

A key point in respect to question (1) is that the increase in the foreign investor presence has been concentrated at the short end.

Although deeply concerned about Japan’s fiscal situation, we believe foreign investors have noted the stable JGB uptake by domestic investors and they do not expect Japan to see a full-blown crisis within the next 12 months or so. They therefore do not require a fiscal premium on short-term JGBs. Forex swap market distortions caused by the European crisis has been another reason for them to invest in short-term JGBs, in our view.

In respect to question (2), we think it depends crucially on how long the European crisis will continue. As long as Europe is in a crisis mode, foreign investors are likely to seek temporary and liquid sovereign safe havens, such as JGBs, as alternatives to European bonds. Thus, we think it is possible that the foreign ownership ratio can increase further from the current 8.3%. That said, we do not expect the ratio to accelerate to far above 10% any time soon. This is because (1) foreign investment has been skewed to the short end and (2) once concerns over the European situation ease, we would likely see foreign investors shift back to European bonds.

Policy implications

We believe it is very difficult for the Japanese government to stabilize the debt/GDP ratio. Our analysis suggests that unless the government makes more aggressive budget cuts than the current plan, domestic funding may become difficult in 6-7 years’ time, meaning that Japan would need more financing from foreign investors. Higher JGB yields would be required to attract foreign investors, possibly triggering a negative spiral in which debt service costs rise and the fiscal situation becomes even more severe.

This is why we think measures such as consumption tax hikes are important. In isolation, they will not stabilize the debt/GDP ratio, but larger annual tax revenues are needed to fund fiscal expenditures, even if this merely keeps the wheels turning. The government will also need to address Japan’s narrow tax base and inefficiencies in tax collection, in our view.

To tackle the solvency issue effectively, we believe the government will need to accompany tax increases with decisive spending cuts, including severe cutbacks in social security spending, although we think deep cuts in social security spending are unlikely in Japan’s current political climate. One important lesson learned from previous fiscal consolidation cases is that the expenditure-cut approach has resulted in substantial debt reduction on average. By contrast, the tax-driven approach tended to have the reverse effect.

Market implications

For the next several years, we do not expect a sharp rise in JGB yields triggered by a sell-off by foreign investors. This is very different compared to the situation in European countries such as Greece and Italy. Although the foreign ownership ratio has increased recently, investment has been skewed towards the short end. Even if we were to see heavy net selling of short-dated JGBs by foreign investors, we would not expect major market jitters given that the Bank of Japan (BoJ) can resort to a variety of operations to increase the supply of funds and thus calm markets.

This leads to the question of whether domestic investors would sell off JGBs on their own initiative. We think the ultimate anchor for domestic JGB investors is the belief that there is scope to cut spending/raise taxes in the future. If this belief is shaken, we would expect them to consider moving out of JGBs. That said, we would still not expect an immediate surge in JGB yields1. Our reasoning is that (1) there is no ready alternative for funds equivalent to twice the GDP of the world’s third-largest economy, and (2) the BoJ is expected to make JGB purchases to support yields.

Another catalyst for a sell-off by domestic investors is if Japanese manufacturers make greater-than-expected overseas production shifts (overseas M&A). Overseas M&A activity has accelerated, driven by shrinking domestic demand and a strong yen, among others. According to our analysis, this trend will bring forward domestic financing difficulties, because such long-term capital outflows cannot be considered as a ready domestic funding source for fiscal deficits. Overseas production shifts also mean a loss of employment opportunities in Japan, which would lead to slower nominal GDP growth, which is closely related to tax revenues in Japan.

Lastly, if Japan’s finances collapse and JGB yields do spiral, we would not expect contagion to the US or Germany given that Japanese investors would likely seek refuge in US and German bonds—in the same way that investors have fled the European crisis—and foreign investors would increasingly resort to ”safer” assets for the time being.

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Is the Japanese debt situation the worst in the world? The US has an unbelievable amount of contingent and unfunded liabilities. The US is backing over 90% of every single newly issued mortgage in the US. Housing is the most expensive asset (or liability nowadays) that most people have, need I say more? (And there is a lot more to say)

The japanese have been buying our treasuries the last year apparently, we have been shitting on them for the last 30 years.....we have been sending them toxic shit from the beginning of time now they have their own toxic problem as well in more ways then one........I'll give eveyone credit for keeping this toxic worldwide pool running though I can't believe this whole thing hasn't caved yet

Opposition to fiscal and monetary stimulus is more than misguided - it’s downright immoral. Japan’s economic condition is a result of fiscal and monetary cowardice. It has to be said that libertarians who oppose stimulus packages are effectively responsible for the preventable poverty that ensues. I am sickened by that the BOJ’s monetary impotence, which has cost the Japanese people billions of Yen in lost wages and forgone job opportunities. I hope that America will not make the same mistakes as Japan, and will continue the necessary monetary easing and fiscal stimulus untill wages, unemployment and GDP have reached acceptable levels. AFTER we have achieved these goals, THEN we can start worrying about the “inflation” that paranoid doomer libertarians are so obsessed about.

Dude, Japan has been QEing, liquidity injecting and propping up their banks for the last twenty years in one form or another. Besides uncle Benny totally screwed the UK's economy by QE2 due to elevated inflation levels which exceeded quite a bit wage increases, so consumer spending power was eroded. The rate at which things are going, the cure will likely poison the patient...

I wholeheartedly agree. The conservative, nay, outright timid, Japanese government is in the condition they are in precisely because they haven't been spending enough. If they were to begin a phase of militarization, then they could easily grow their way out of their doldrums. Military spending has really been beneficial for the US to grow its way out of each and every period of economic malaise.

OTOH, we could learn a lot from the Japanese as well! If Americans would stop wasting so much money on consumerism (which is ruining the economy!!) and buy more government bonds, the US would be able to more independent in terms of our deficit spending.

To add to Major Debilitated Brainstorm thinking,Japan should build crappier product. Keynesian krap, so that there is more demand. The Soviet's always had labor shortages, jobs, and very little debt. Proof positive that a people under the hand of an anointed class can prosper.

Offthebeach - i don't remember the Soviets "prospering" ...seem to recall a slow consistent grind down the sewer followed by complete and total bankruptcy in 1989

the Berlin Wall didn't come down because of politics, it came down because of economics. The Communist scum were all out of other peoples money having destroyed everything productive in the economy (a Govt speciality both East and West)

Sadly, you cannot pump trillions into the economy WITHOUT triggering inflation - just because the CPI is basically unmoved doesn't mean there's no inflation. Gas prices, basic foodstuffs, etc., are all going up in price. Just because some twerp in Washington tells you there's no infaltion, doesn't make it so.

Keynesianism has a 100% rate of failure, but you silly lefty do-gooders wnat to try it again and again. You know what actually fixes broken economies? Liquidations, bankruptcies, business contractions and all the other market mechanisms that your social-engineer-in-chief thinks he can subjugate. He cannot, and all we are doing is prolonging the agony.

Death by a thousand cuts is still death.

Printing money doesn't work. It never has, and never will - have you ever heard of a country with a central bank that was able to unwind hyper-inflation? You haven't? Do you know why that is?

What most people dont realize is that Sweden actually has a big debt problem. Our government has done a nice job cutting our sovereign debt from the 90's crash. But, long term low interest rates are pushing private credit expansion out of control. Swedes are among the most indebted people in the world.

Unfortunately our politicians didnt learn their lesson from the 90's. The housing market is basically in a coma and stands before a total collapse. Of course nobody belives it, yet. A couple of percentage points in rising unemployment and the fairy tale is over.

Before joining the Canadian public service, Carney spent thirteen years years with Goldman Sachs in its London, Tokyo, New York and Toronto offices. His progressively more senior positions included co-head of sovereign risk; executive director, emerging debt capital markets; and managing director, investment banking.

Goldman's role in the Russian crisis was criticized at the time because while the company was advising Russia it was simultaneously betting against the country's ability to repay its debt

The last laughable report from Goldman Sachs about Japan declared that Japan could solve their problems if only the women in Japan would work. Read it first hand from the Zionist spokesmouths that occupy The Atlantic.

Hey. Guess what Goldman Sachs. The women in Japan don't have to work. Especially not because you say so. Maybe they like being housewives. Maybe they think it's important to take responsibility for their kids. Maybe they think your women's economic liberation theory is complete bullshit and the Israelis and Americans can shove their women's equality theories up their asses. Maybe it's better for a country if mothers raise happy, intelligent, capable new generations of citizens. Maybe they think you should worry more about your own shit and quit lusting after theirs for decades and decades. You fucking useless parasites.

Why don't you ask General Electric. They're the ones that sold the nuclear shitpipes to Japan, with the aid, abettment, and machinations of the US Government. Hey. Here's a thought. Maybe the US / GE consortium planned to finish up the job they didn't complete with the first 2 atomic bombs. Who knew.

"TEPCO and JAPGOV didn't have to buy any reactors...GE brand or otherwise."

Au contraire, asshole. Japan has been a vassal state of the US ever since the US nuked it...because the Japanese were about to surrender and American cocksuckers wanted to see what N-bombs would do to Japanese babies and Grandmas.

The US most definitely rammed the crapola technology down their throat. And even if it didnt, its obvious that GE doesnt know the meaning of customer service on their shitty reactors. Just anothe US GOVCO like GM and BP, that should have never survivded their braindead management.

But then again, the US is braindead. Bunch of crackheads who dont hold a candle to Japanese technologies. Where do you think all the thinfilm copper in iPhones comes from? Inner Detroit??

"And I think anytime any country builds a nuke plant on a near a fault line/zone they are asking for the inevitable."

You mean like Cali? Those nuke plants need ALOT of water compared to coal or NG power generation with the caveat that the water will become unusable and have to be disposed of properly after going through the plant. Faustian bargain.

The USA sells Japan the big ticket items, like GE reactors, Boeing aircraft, and Aegis cruisers. Japan sells the USA small ticket items like cars, motorbikes, gasoline wasting internal combustion engine wanker toys, and TV sets. That is the deal: one Boeing aircraft goes west 5000 cars go east. Anyone remember the UAW steamrolling Celicas in the 80's???? Not a peep out of the media then, or now. The "Buy American" crowd didn't have a clue then or now how this game is played.

I certainly trust Kyle Bass more than GS. He's a patient investor. And I suspect he sees a much different timeline than Goldman. Remember GS wants to keep you off guard while they set up their own position. They'll let you know that they think the JGB situation is going to be problematic after they have their shorts well established.

Kyle Bass has been losing millions, and the Japan 'collapse' he wants is not likely to happen fast enough.

As it says above re Japan ...

« ... the deficit can comfortably be funded domestically through FY2020 ... »

Sh*t, that is a long f*cking time that Japanese people are still going to be buying their country's debt ... 200 or 300% of GDP notwithstanding

People really underestimate the kick-the-can abilities of government and central bank finance in these deep-credit advanced economies

All these people losing money betting that Japan will blow up ... the euro-zone will blow up ...

When it just isn't the same as a household economy

Though I do enjoy reading Jim Willie of 'Golden Jackass' on how the US Treasury house of cards 'Tower of Babel' is going to blow up pretty damn soon once the Interest Rate Swap corruption game collapses ... Must admit I would like to see America go bust and some Americans grab their freedom back again ...

2020 is beyond anything fathomable in terms of the current >>>global debt <<< Japanese health care industry to deal with the cases of thyroid cancer and lukemia among other radiation maladies related to this crisis...

...The fact that the Japanese are >>>buying US or German debt paper<<< sitting on an island with four spewing reactors means that they are will be fleeing from their own >>>paper<<< island soon.

Just Okinawa prefecture. And the biggest US airbase in pacific is also in Okinawa. They are there as possible retaliatory forces agaist N Korea. The SOFA agreement with ROK limits number of US boots on the Korean peninsula.

Right now there's a lot of tension between Japan and Korea as well as Japan and China.

Tell you what. You convince me with any reasonable logic that our Government is actually using current tax revenue effectively - instead of, you know, browsing child porn while on the clock, or throwing expensive junkets at taxpayer expense, etc. You convince me that we are squeezing every penny out of current revenue and there could be an argument that the Govt just needs more $$$ !! But we both know that won't happen, because you cannot make any reasonable argument whatsoever that doesn't involve a crackpipe somehow.

Worry no more. The Obama administration has sent the Curiosity to Mars, the rover successfully landed and is now in a (desperate) search for (any) life forms which we can burden our debt to. Algae, bacteria, anything goes.

Japan is a case study of the post-growth economy. The historical private sector savings has afforded them time to recalibrate expectations. By the time their borrowing capacity ends, they'll have adjusted their living standards back to the point of neofeudalism.

What is strange is that Japan is buying US Treasuries faster than the Chinese are now.....why in the hell are they buying US treasuries???? If I was sober this would really get to me...but its a strange strange world we live in...Econ 101 no longers works....so I no longer invest...I just sit on the sidelines and get drunk...just crazy

JPY is strong despite their economy is shit, which is hurting their export-driven economy that relies on auto and tech industries. Japanese government buys UST to devalue Yen relative to Dollar. See, when JPN government wants to buy UST, they make up a whole wad of newly printed JPY and exchange them with USD. This in effect adds to supply of Yen and demand of Dollar, causing Yen to be weaker relative to Dollar. Buying foreign bonds with shit fiats to lower exchange rate has been one of the favorite moves of Japanese government. What is strange is how Yen continues so strong in the past 5 or so years despite endless QEs, chronic deflation, aging population, nuclear disaster and downfall of their auto and electronics industry. Regarding how Japan can maintain such obscene debt/GDP ratio, I have a theory: most of the debt are owned by their own people, and Japanese people are extremely submissive to the authority compared to their western counterparts. Therefore when the eventual SHTF moment arrives, the gubermint can get away simply by saying "sorry, no money. what you gonna do? rong rive zeh emperor!"

So what if the Japanese government goes tits up? The government fails and the people form some other type of government. Will they continue to be an ecominic power, no, but they won't be going mad max either. Their demographics are too stable. That is not the case in most other countries. The U.S. has so many demographic fault lines that when the shit hits here polite society will shatter like a cheap Shrek glass from BK.

Yeah, the U.S. is screwed. The elite whites and Jews screwed themselves, thinking they could pay off the blacks forever, and that there's an infinite amount of rednecks, Mexicans, and Asians to do the work.

Solvency isn't something that gets tested (and rarely matters) as long as there is sufficient cash flow.

Most people think in terms of solvency. Which is why they are so shocked that things keep plugging along despite the "deficits." The whole world is kiting checks now. Anyone surprised?

The rubber meets the road when liquidity freezes. Liquidity freezes when somewhere a critical chain of trust is lost. No one wants to be that guy... unless there is something in it for him that is. As pressure mounts, who knows. The game could change. But, for right now it is a circular firing squad.

Well, you know and I know that it can't be butterflies and roses for everyone forever. Even with a One World government or the idea that they all agree to accept each other at face value and pretend they've got something. When we least expect it, something will break and it will all collapse under its own weight. I don't care what they tell us. I care about what they don't tell us.

+1. It is why the "crash" will most likely happen without warning. No different than a poorly run business wherein one day unsuspecting employees show up and the doors are chained shut. If this was about fundamentals of solvency, it would have been over a long time ago.

Great analysis, and I was fully onboard until I read, " (2) once concerns over the European situation ease, we would likely see foreign investors shift back to European bonds." - which I read as, "hope." Come on! This genius assumption ruined the whole article imho. Europe is a fucking lost cause, in case you haven't noticed.

Japan is the founding pioneer nation when it comes to balance sheet depression chart porn. Too bad they couldn't keep the Nikeii at near record levels like some other developed country we know ( @ 8/20/12 ).

This is pretty sensical to me. Sure, JGB yields are low, low, low but isn't this 'phenomena' simply a symptom, a symptom which ZH has been warning about for years? In August of 1998 the USD/JPY was trading @ 147.65 juxtaposed against current levels of 79.41. So the rate at which they borrow is a give/take relationship is it not? The higher their debt-to-gdp ratio increases the greater the loss of purchasing power the Japanese people have. Has ZH not been warning about the dollar losing it's reserve status due to fiscal imprudence?

While market mavens like Kyle Bass have prognosticated and even put their money where their mouth is, is it still not true that markets can remain irrational longer than you can remain solvent? Interestingly enough the European crisis buys Japan time, and even more interestingly the US has it's own 'fiscal cliff' approaching and while I am confident some compromise will be made it could be another 11th hour 59 minute save where markets swoon and force the hand of our politicians. The EZ will most likely prolong their own collapse by force feeding bullshit rumors ad infinitum.

So while I don't disagree with the premise of the underlying, who collapses first is a heroic bet to make. Who's to say the USD/JPY doesn't hit 40 while Japan continues to borrow at low rates? The US could have a 10yr @ .05% but how much does that matter if the price at the pump is $30 per/gallon?